The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor's potential return on their investment in the real estate market. Cap rate is most useful as a comparison of relative value of similar real estate investments.
Example: Capitalization Rate = Net Operating Income / Current Market Value
Property current market value = $300,000.
Rent is $2,700 per month x 12 = $32,400 annually
Annual Operating expenses = $7,800
$32,400 (annual rent) - $7,800 (annual expenses) = $24,600 Net Operating Income (NOI)
$24,600 (NOI) / $300,000 (property value) = .082 x 100 = 8.2% Cap Rate
Note: Net Operating Income equals all revenue from the property minus all reasonably necessary operating expenses. NOI does not include taxes, principle, interest, depreciation or capital expenditures.